When stars align

With every bear market comes opportunity

Ian Tam, CFA 14 April, 2020 | 1:15AM

Night sky

Editor's note: Read the latest on how the coronavirus is rattling the markets and what you can do to navigate it.

Year-to-date, the S&P/TSX Composite index has unfortunately treated investors with a bitter 19% decline after being hit by the triple-decker of economic worries around COVID-19, a gargantuan drop in oil prices, and a couple of surprise interest rate cuts. Although the circumstances and reactions from the central banks may be different this time around, for experienced investors, they’ve been through this before – September 2009, February 2002, August 1998, and June 1982, to name a few.

Put best by an eerily relevant quote from our GARP-father Peter Lynch to the National Press Club in 1994: Human nature hasn’t changed a lot in 25,000 years. Something will come out of left field, and the market will go down, or the market will go up. Volatility will occur and markets will continue to have these ups and downs - I think that’s a great opportunity, if people can understand what they own.”

Echoing Lynch’s 26-year-old statement, this market correction may offer an opportunity for those with the resolve of a disciplined investor, and it’s about time. Valuations in Canada have not reached these levels since the days of the financial crisis.

Exhibit 1: Median price-to-book ratio of large stocks in Canada

Exhibit 1

Source: Morningstar CPMS™

The above chart illustrates the median price to book ratio of the largest companies in Canada. Recall that the book value of a company’s equity is what remains if they were to liquidate all assets and pay off all debts. The price to book ratio can be a useful measure of valuation in uncertain times as the book value does not fluctuate as rapidly as say earnings or sales, giving us a more consistent point of reference. As shown in the chart, today’s price to book ratio for large stocks in Canada (consisting of the largest 115 companies by market float) sits at about 1.6x, that’s curiously close to valuations at the low point of the financial crisis, and below that of the oil crunch of 2015. For reference, the long-term median price to book ratio over the last 35 years is close to 2.0x.

On a stock-specific level, a powerful yet convenient way to gauge how under or over-valued a stock is, is to look at a company’s star rating from Morningstar. Unlike the star rating for funds and ETFs the star rating for stocks stems from our global team of 120 analysts that provide qualitative research on companies. Like the rest of Morningstar, our equity analysts are independent which is an important aspect especially for stocks as our analysts are not tied to an investment bank and hence do not share the same perceived biases that sell side analysts might have. The equity star ratings are a representation of how a stock’s price compares to its fair value estimate. Companies with five stars are trading below their fair value (an opportunity to buy) while companies with one star are considered over-valued. In Canada, Morningstar’s analysts cover 72 Canadian companies.

Exhibit 2: When stars align
Exhibit 2

Source: Morningstar CPMS™

For the first time in 11 years, the average star rating for our coverage universe is four stars. This is certainly a rare occurrence and tells investors that there is opportunity to be had in equities. For a starting point for more research, here are a list of some of Canada’s largest dividend paying five-star companies:

Table

This article does not constitute financial advice. It is always recommended to speak to a financial advisor or investment professional before investing.

About Author

Ian Tam, CFA  is Director of Investment Research at Morningstar Canada. 

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